Commentary

How to make our tax system less painful

Commentary: At age 100, time is right for federal tax code overhaul

By

J.J.Zhang

Columnist

J.J. Zhang is a chemical engineer and amateur financial adviser who was the winner in MarketWatch’s second annual World’s Next Great Investing Columnist contest. He runs the blog MarketTech Reports. You can follow him on Twitter @MarketTechRpts.

The 2012 tax filing year has ended — for those who did not file for an extension — and as always paying taxes was a thoroughly unenjoyable experience.

It’s become an annual rite of passage for working adults and now an ingrained part of our yearly life. But little noticed was the fact that 2013 marks the 100th anniversary of the modern U.S. federal income tax. So how well has our centenarian aged over the years?

Historically, governments in the distant past focused on property and excise tax as the primary income source, not labor. The first U.S. federal income tax was not levied at the founding of the country; instead it occurred almost 70 years later in 1861 to pay for the Civil War. The tax bracket for the Civil War income tax was 3% on income over $600 and 5% on income over $10,000.

After the war, the income-tax law expired in 1873 and labor was again tax free. For the next 40 years, various attempts at income tax were tried but ruled unconstitutional until the passage of the Sixteenth Amendment giving Congress the power to tax in 1909. Shortly after final State approval in February of 1913, the first 1040 form appeared with a 1% tax on income over $3,000 ($70,000 today) and 7% on income over $500,000 ($11.8 million today).

The first forms were relatively simple, three pages of calculations: one on net income, one on gross income and one on deductions with less than two dozen total questions. The modern 1040 numbers nearly 80 questions not including additional attachments, schedules and forms. Why is it called the 1040? The number was next in the government forms control numbering system.

In accordance with the complexity, a whole (highly profitable) industry (estimated at $6+ billion annually) has popped up to deal with it. There is an estimated 900,000 to 1.2 million tax preparers in the country, almost double the number of law-enforcement personnel and quadruple the number of firefighters. They make up one out of every 200 adults living in the country. That number is almost one-third of the entire U.S. population during the revolutionary war.

Compliance is time consuming and expensive. The Government Accountability Office in a 2005 report estimates a lower range cost of $100 billion to $150 billion for individual and corporate tax compliance cost. Other reports estimated compliance costs of 2-5% of GDP, a figure that if accurate would represent up to $750 billion today.

This is money that could have been spent on food or housing, or invested in capital and starting new businesses. On top of that cost, taxpayers also pony up almost $12 billion per year to keep the IRS going.

Beyond just the dollar cost, there is also the time and headache associated with filing our taxes. The IRS estimated compliance times for filling out the 1040 at over 13.5 hours in 2004, not insignificant when multiplied by the number of people filing.

A new tax system?

While I dislike taxes as much as everyone else, I do recognize the important services that our tax money pays for and the ultimate necessity — well some of it at least. However, with the high time and money cost associated with our current system, there must to be better ways to go about it.

So what can be done to simplify not just the tax system but also the tax collection part? One small but visible and useful proposal is through implementing some form of a return-free filing system.

Internationally, there are several alternatives to the current U.S. withholding and filing system. Many countries such as the U.K. and Japan employ a system where tax liabilities are automatically determined and adjusted so that many do not file returns.

These proposals take advantage of the fact that most Americans have relatively simple situations and that the IRS already has the relevant information on their income and tax liability. Using that information, the IRS can provide you with precalculated and precompleted documents, either mailed or via the Internet, for you to review and confirm or contest the result.

Imagine if filing your tax return is as simple as going to the IRS website, entering your login information, double checking your income and deductions and clicking done.

For taxpayers with more complex situations, such as investors with interest, dividend and capital gains, significant changes to the tax code and reporting structure would have to be made to simplify their returns to the same degree. However some of these changes are already being implemented, thanks to the bailout bill of 2008, which instituted mandatory cost-basis reporting to the IRS.

Given that many of these proposals can be implemented today, the question is why hasn’t anything happened? It has been piloted in some limited cases, such as California’s ReadyReturn program.

With tax reform starting to be discussed in Washington again, the time is right to call for simplification of both the tax code and the filing process.

J.J.
Zhang

J.J. Zhang is chemical engineer and amateur financial adviser who was the winner in MarketWatch’s second annual World’s Next Great Investing Columnist contest. He runs the blog MarketTech Reports. You can follow him on Twitter @MarketTechRpts.

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J.J.
Zhang

J.J. Zhang is chemical engineer and amateur financial adviser who was the winner in MarketWatch’s second annual World’s Next Great Investing Columnist contest. He runs the blog MarketTech Reports. You can follow him on Twitter @MarketTechRpts.

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